Friday, February 19, 2016

Kashkari on TBTF

Neel Kashkari, the new president of the Minneapolis Fed, is making a splash with a speech about too big to fail, and the need for a deeper and more fundamental reform than Dodd Frank. I am delighted to hear a Federal Reserve official offering, in public, some of the kinds of thoughts that I and like-minded radicals have been offering for the last few years.

I believe the biggest banks are still too big to fail and continue to pose a significant, ongoing risk to our economy.

Now is the right time for Congress to consider going further than Dodd-Frank with bold, transformational solutions to solve this problem once and for all.

From an economic point of view, now is indeed the right time -- calm before the storm. I'm not so sure now is a great time from a political view! But perhaps anti-Wall Street feelings from both parties can be harnessed to good use.

...When the technology bubble burst in 2000, it was very painful for Silicon Valley and for technology investors, but it did not represent a systemic risk to our economy. Large banks must similarly be able to make mistakes—even very big mistakes—without requiring taxpayer bailouts and without triggering widespread economic damage.

This is a key lesson. As Dodd-Frank spreads to insurance companies, equity mutual funds, and asset managers, we're losing sight of the idea that trying to stop anyone from ever losing money again is not a wise way to prevent a panic. It's the nature of bank liabilities, not their assets, that is the problem.

I learned in the crisis that determining which firms are systemically important—which are TBTF—depends on economic and financial conditions. In a strong, stable economy, the failure of a given bank might not be systemic. The economy and financial firms and markets might be able to withstand a shock from such a failure without much harm to other institutions or to families and businesses. But in a weak economy with skittish markets, policymakers will be very worried about such a bank failure.

In other words, the whole idea of designating an institution that is per se "systemic" is silly.

...there is no simple formula that defines what is systemic. I wish there were. It requires judgment from policymakers to assess conditions at the time.

Here I think Kashkari isn't really learning the lesson. If it's undefinable, even in words, and needs "judgment," then perhaps the idea really is empty.

More deeply, I think we need to apply much the same thinking to regulation that we do to monetary policy. At least in principle, most analysts think some sort of rule is a good idea for monetary policy. Pure discretion leads to volatility, moral hazard, time-inconsistency and so on. We should start talking about good rules for financial crisis management, not just ever greater power and discretion to follow whatever the "judgment" (whim?) of the moment says.

A second lesson for me from the 2008 crisis is that almost by definition, we won’t see the next crisis coming, and it won’t look like what we might be expecting. If we, or markets, recognized an imbalance in the economy, market participants would likely take action to protect themselves. When I first went to Treasury in 2006, Treasury Secretary Henry Paulson directed his staff to work with financial regulators at the Federal Reserve and the Securities and Exchange Commission to look for what might trigger the next crisis... We looked at a number of scenarios, including an individual large bank running into trouble or a hedge fund suffering large losses, among others. We didn’t consider a nationwide housing downturn. It seems so obvious now, but we didn’t see it, and we were looking. We must assume that policymakers will not foresee future crises, either.

This is an unusual and worthy expression of humility. Others advocate loading up the Fed with "macroprudential" regulation and "bubble pricking" tools, on the faith that this time, yes this time, they really will see it coming, and really will do something about it. Regulators are not wiser, smarter, less behavioral, etc. than traders.

Speaking of the "resolution authority,"

Unfortunately, I am far more skeptical that these tools will be useful to policymakers in the second scenario of a stressed economic environment. Given the massive externalities on Main Street of large bank failures in terms of lost jobs, lost income and lost wealth, no rational policymaker would risk restructuring large firms and forcing losses on creditors and counterparties using the new tools in a risky environment, let alone in a crisis environment like we experienced in 2008. They will be forced to bail out failing institutions—as we were. We were even forced to support large bank mergers, which helped stabilize the immediate crisis, but that we knew would make TBTF worse in the long term.

There are no atheists in foxholes, the saying goes. Notice "forcing losses on creditors and counterparties." This is exactly right. "Bailouts" are not about saving the institution, they are about saving its creditors. We should always call them "creditor bailouts." And a run is in full swing, and when the hotlines to the Treasury are buzzing "if we lose money on this, then the world will end," anyone in charge will guarantee the debts.

I believe we must begin this work now and give serious consideration to a range of options, including the following:

Breaking up large banks into smaller, less connected, less important entities.

Here, Kashkari caused a stir in the press. Bernie Sanders voiced approval. Since "breaking up" has no subject -- who is to do this and how? -- and no mechanism, I'll give Kashkari the benefit of the doubt that he had something more sophisticated in mind than brute force.

Turning large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail (with regulation akin to that of a nuclear power plant).

Aha! My favorite simple solution, more capital! I'm delighted to hear it. Of course (to whine a bit), banks don't "hold" capital, they "issue" capital -- it's a liability not an asset. And if they have so much capital that they virtually can't fail, what is this business about public utilities? And why in the world do they need regulation akin to that of a nuclear power plant? Given how regulation has spiraled costs, stultified innovation, and stopped expansion of the one scalable carbon-free energy source we have, that's a particularly unfortunate analogy. Or maybe it's an incredibly accurate analogy for just where Dodd-Frank style regulation will lead. The point is the opposite: with "so much capital that they virtually can't fail" they don't need the hopeless project of "systemic" designation, intensive asset risk regulation, and so forth.

Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.

A Pigouvian tax on short term debt -- after we get rid of all the subsidies for it -- is my other favorite answer.

The financial sector has lobbied hard to preserve its current structure and thrown up endless objections to fundamental change.

Many of the arguments against adoption of a more transformational solution to the problem of TBTF are that the societal benefits of such financial giants somehow justify the exposure to another financial crisis. I find such arguments unpersuasive.

This needs some explanation. Banks produce studies claiming that higher capital requirements or reduced amounts of run-prone short-term funding will cause them to charge more for loans and reduce economic growth. Kashkari is pointing out that these arguments are pretty thin, because the cost of not doing it is immense -- 10 percent or so of GDP lost for nearly a decade and counting is plausible.

Obviously, I don't agree with everything in the speech. Kashkari is a bit too vague about "contagion" "linkages" and so fort for my taste. But the good news is to have this conversation, and not settle in to implementing page 35,427 of Dodd Frank regulations, head in the sand, while we wait for the next crisis.

The rest of the speech outlines his plans to get the Minneapolis Fed working hard on these issues, and to push for them at the larger Fed. This is a project worth watching.

In case I haven't plugged it about 10 times, my agenda for these issues is in Toward a Run-Free Financial System and the many blog posts under the "banking" "financial reform" and "regulation" labels.

26 comments:

It's not mine. First, a Pigouvian tax is a negative incentive. Instead use positive incentives - they are more politically appealing. Instead of saying we want to punish institutions for using short term debt, say we want to reward institutions for using long term debt / equity.

Second, any tax policy that seeks to favor equity / long term debt over short term debt must accommodate the yield curve - the difference between short term and long term borrowing costs. It's not enough to say we are going to assess a fixed 3% tax on short term borrowing if the spread can change from 7% to 1% to 5% over time.

Why would we need to break up risky TBTF banks if the proposed changes, such as capital requirements, would make them safe? By definition they'd no longer be too big to do any systemic harm.

If financial crises are unpredictable in both timing and nature, how do we know under what conditions the banks are guaranteed to be safe?

I'm really encouraged by his candor and appreciate that he has put this back in the public spotlight (perhaps only the 68% of the public who knew who Antonin Scalia was*) and look forward to hearing more from Mr. Kashkari.

I agree with about 95% of the above article. Just a few minor quibbles….

JC is of course right to say that if runnable liabilities are removed from banks balance sheets, there’s no need for the “nuclear power plant” style regulation. But more than that: there’s no need to break up TBTF banks. That is, if it’s effectively impossible for banks to fail, then why bother breaking up large banks? And if some bank wants to become so large that diseconomies of scale set in, then let it! Allowing firms to make mistakes and suffer to consequences is all part and parcel of free markets.

Frank,

Re debt and “how short is short term”, obviously banks (or more accurately “entities that lend”) can in theory be allowed to keep SOME debt on the liability side of their balance sheets. E.g. if a bank is funded 50% by equity (quite common in the 1800s) and 50% by longish term debt (say 2 months minimum) then it is pretty well bomb proof. But the big problem is that regulators and politicians are a bunch of cuckolds: they’ll fall for any old sob story from banks about “economic growth” being improved by cutting down on that 2 months or allowing banks to lever up. So I think much the simplest and best solution, which I think JC favors, is a simple ban on ALL DEBT i.e. all runnable liabilities.

1. Banning all bank debt (presuming we can agree on the definition of a bank), implies that a bank must sell equity shares to lend money.

2. Banning all short term debt means either the central bank no longer exists as lender of last resort or the central bank makes loans for periods longer than short term.

3. Banks (primary dealer banks) are by far the largest single purchaser of government debt at auction.

Convince me that banks will be willing to sell equity shares to purchase government debt. I don't think you can. The moment the federal government tries to impose equity requirements on banks, those banks will turn their noses on government debt auctions.

You can argue that the federal government can borrow from other countries and I would make the same argument, private banks can borrow short term from other central banks - so what have you really accomplished?

If your "BAN ALL DEBT" statement, really means all debt at every level (public and private), then you are into government fiat money or barter in which case the need for any kind of bank (private or central) or banking regulation disappears. And you really think that has any chance of happening?

You say “Banning all short term debt means either the central bank no longer exists as lender of last resort…”. Quite right. And the reason is that there is NO NEED for a last resort lender and for the simple reason that for a commercial lender (aka bank) funded just by equity, insolvency is impossible to all intents and purposes.

Putting an end to lender of last resort would be thoroughly beneficial: there’s no excuse for banks being pampered with a lender of last resort facility, while car makers, restaurants etc don’t enjoy the same luxury. At the height of the crisis, the Fed loaned about $0.6tr to sundry banks at a derisory rate of interest. That equals a huge subsidy of private banks.

Next, you say “Convince me that banks will be willing to sell equity shares to purchase government debt.” I’m baffled as to why people WOULDN’T buy shares in a business whose main activity is dealing in government debt. People buy shares in business which do everything from making cars to mining gold to every conceivable activity.

Moreover, under full reserve banking (at least as envisaged by Milton Friedman, Lawrence Kotlikoff and others), banks DON’T sell shares so as to purchase government debt. Under full reserve, the bank industry is split in two. On half offers depositors 100% safety (or something as near 100% safety as is possible in this world). That half simply dumps depositors’ money at the central bank and/or invests in government debt. I.e. it’s DEPOSITS which fund government debt purchases, not, as you suggest, shares.

However, it could well be argued that a distinction should be drawn between dealing in relatively LONG TERM government debt and short term debt (which comes to almost the same thing as cash). But that’s no problem. We just have a rule which says something like “the purchase of government debt with more than one year to maturity must be funded by shares, not debt”.

Re your last para and your claim that I’m advocating a “ban on debt”, advocates of full reserve do not advocate a ban on all debt. They advocate a ban on funding loans by debt: that’s loans which are more risky than government debt (i.e. mortgages, loans to small businesses, etc).

"I’m baffled as to why people WOULDN’T buy shares in a business whose main activity is dealing in government debt."

Because they can buy the debt themselves if they so choose. Currently, anyone is permitted to participate in a U. S. government bond auction. Why would I buy shares in a bank whose only purpose is to buy and sell government debt, when I can buy and sell the debt of my own accord?

"We just have a rule which says something like the purchase of government debt with more than one year to maturity must be funded by shares, not debt."

You still haven't convinced me that people will buy shares of a bank that only deals in government debt.

What do these 100% safe banks offer me that I can't do myself, and why would I ever invest in them?

Re your claim that people would not buy shares in a firm that deals in government debt, that’s contradicted by the fact that people buy into money market mutual funds whose only assets are base money and government debt. Those MMMFs are in effect retailers. That is, some central banks (like wholesalers of all sorts) are not interested in having millions of customers: they want to stick to the wholesale business, i.e. just have a few customers. And in the UK there’s “National Savings and Investments” which a state run savings bank which does much the same as the above MMMFs.

Actually to be more accurate, the MMMF business is currently being forced to make the above “base money and government debt only” option available to customers, and that option is proving popular.

Re a “ban on all debt”, what I meant was debt in the widest sense (e.g. including trade debt). In contrast, what JC favors (as do I) is to ban money lenders from THEMSELVES being funded by loaned money, i.e. debt.

Would you seriously show up to a bond auction, briefcase of cash to hand over, receive your bond... then go down the street then swap (part of) your bond for a burrito? What about paying for that new jacket on ebay?

It seems that for any normal life of 21st century you will need to engage with some third party finance provider. Whether you call it Paypal, Revolut, or Bank of America, you'll probably want some banking services beyond the "i'll trade my cash for govt. bonds by myself thank you very much" stubbornness.

"Would you seriously show up to a bond auction, briefcase of cash to hand over, receive your bond.."

You do realize that bonds are sold by the U. S. federal government primarily in electronic form don't you? The days of paper bonds are long gong. And yes, I have in fact purchased U. S. government bonds electronically in the past at auction.

That's fine. Yes, these "safe banks" could offer those services, and I would certainly use these services as a depositor. That doesn't explain why I would buy equity shares in those types of banks. See Ralph's comment above:

"We just have a rule which says something like the purchase of government debt with more than one year to maturity must be funded by shares, not debt."

You have argued that "safe" banks would attract depositors by offering other services. You have not convinced me that banks that buy long term government debt would attract share buyers.

Ralph,

"Re your claim that people would not buy shares in a firm that deals in government debt, that’s contradicted by the fact that people buy into money market mutual funds whose only assets are base money and government debt."

Not so fast. Here is the investment breakdown for a typical money market mutual fund:

http://www.usatoday.com/money/lookup/mutual-funds/PMIXX/

"The fund seeks to achieve its investment objective by complying with the quality, maturity and diversification of securities requirements applicable to money market funds. It may invest in the following U.S. dollar-denominated instruments: obligations of the U.S. government (including its agencies and instrumentalities); short-term corporate debt securities of domestic and foreign corporations; obligations of domestic and foreign commercial banks, savings banks, and savings and loan associations; and commercial paper."

This is quite typical of a money market fund - they buy more than just government bonds and base money. If you can name a single money market mutual fund that only buys government debt, that's fine. Most are not limited in that way.

"Whether you call it Paypal, Revolut, or Bank of America, you'll probably want some banking services beyond the I'll trade my cash for govt. bonds by myself thank you very much" stubbornness."

This isn't stubbornness.

Why do people buy equity shares in any company to begin with?

Could it be that they are seeking a rate of return on their money that is greater than the risk free rate of return?

How do the equity shares of a bank that only buys government debt offer anything more than the risk free rate of return?

Yes, such a "safe" bank could offer other services, but it is likely that funding those other services (paying for employees, equipment, etc.) would reduce the return on investment for shareholders below the risk free rate of return.

Banks already charge various fees for OTC services et al.It’s difficult to find any current or checking account that pays any interest or at least charges no fees.

(Equity funded) narrow banks would indeed need to take some (or all) of bond interest to fund its costs and profits. But for the convenience of the bank services already alluded, there will be plenty of customers…

Perhaps you take issue with the legal status of holding shares in lieu of a demand deposit, shares inherently carrying unsecure status?

But that minor imperfection is just a diversion and easily fixed with proper legal semantics: For example the constitution of such bank may privilege the status of deposit shareholders over common shareholders and prevent itself from acquiring any other liabilities on its balance sheet – in event of failure - only possible through expenses overspending - the commonstock would suffer those (minor) losses first, leaving deposit shares at face value.

You may not like that exact description, but there are limitless possible legal structures to reassure the “depositor”. I’m sure with the appropriate imagination a recipe can be found to assuage your worries and then for the convenience of the narrow bank you’d also sign up…

Of course you probably not put that much money in due to the rate of return.

Unit trusts are another legal instrument that may fulfil the “no-risk requirement” needed for you to put cash in a non-debt narrow bank.

“You have not convinced me that banks that buy long term government debt would attract share buyers.”

“How do the equity shares of a bank that only buys government debt offer anything more than the risk free rate of return?”

They commonstock share holder earns more that the govt. debt rate because the debt interest is preferentially paid to the shareholder in gains / dividends, as per usual market forces. The depositor receives less or nil of the debt interest but receives the usual convenience and services of a bank.

John, consolidation and national wal-mart-ization of the economy cuts across industries. The relentless slowing of NGDP and decline in yields since 1980 has crushed firms in the middle (those who are not big enough to tap public capital markets for expansion and acquisition).

It's all massive conglomerate (Walmart, Citibank) and small specialty (boutique, hedge fund) now. So it's not just banking - policies have given massive incentives for consolidation unto too big to fail.

Give the market incentives to break conglomerates up, and it will happen. The banking question ought to be one of rewarding smallness and specialization. That means removing bailout guarantees thoroughly and entirely. Reintroduce capitalism into banking when banks are not under stress; and watch activist shareholders break the banks up themselves.

Ain't gonna happen, so this reads more like the Fed CYA before DB stress.

"Equity shares sold by a bank (or any other company)are a liability of that bank."

From Dukaime.org, a liability is "a legal obligation, due now or at some date in the future." Common stockholders can influence the management of a corporation as you point out. However, what exactly are the corporation's (one not undergoing dissolution) obligations to its stockholders that are "...due now or at some date in the future?" There are none. Perhaps this is why corporate balance sheets, at least in the U.S., routinely distinguish between its "liabilities" and its "stockholders' equity."

Economists who speak to a larger audience than just other economists would be better understood if they used terminology common to the broader business community.

"However, what exactly are the corporation's (one not undergoing dissolution) obligations to its stockholders that are...due now or at some date in the future?"

The stockholders can demand their money back by instructing / voting for a CFO that will purchase back all outstanding shares. Of course this buyback cannot supersede debt repayment, but the corporation must honor the wishes of it's voting stockholders. This can occur even when the corporation is not dissolved.

The last company that I know of to go from publicly traded to privately held was the Dole Corporation.

Question: why do not major players in the banking industry simply say, "We want higher reserves and no Dodd Frank. We will accept 50%+- reserves in exchange for a single page of regulations."

If you look at the American Banking Association website, there are some quibbles about Dodd Frank and community banks, but the rest of the site is about how to comply with Dodd Frank, and apparently no proclamations about the evils of Dodd Frank.

Given the well known problems of regulatory capture of regulatory agencies, that may be the worst news of all!

Re why don’t we have a big increase in reserve requirements, the answer is that for every dollar of extra reserves, private banks’ liabilities rise by a dollar, so that doesn’t increase bank safety. Here’s an ultra simple illustration.

Assume to start with there’s just one private bank which has loaned out $X and that recipients of that money deposit it at the bank. Also, to keep things simple, assume the bank has no shares. The bank’s assets will then be $X of loans, and liabilities will be $X of deposits.

Next, assume the central bank / government creates $Y of base money (aka reserves) and spends that into the economy. That will then be deposited at the private bank, which in turn will lodge that base money with the central bank. So the private bank’s assets will now be $X of loans and $Y of reserves. And it’s liabilities will be the $X initially deposited, plus the additional $Y it got from the $Y of base money issued by the CB/govt.

In both cases, the value of the loans only have to fall a small amount, and the private bank is technically insolvent (or ACTUALLY insolvent if there’s a run on the bank.)

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!